Even as market reactions to COVID become more nuanced, CIO encourages investors to reevaluate their hedging strategies
With the approaching second anniversary of the COVID-19 pandemic, investors don’t have to look hard for signs of uncertainty and fear in the markets. For Bill DeRoche, one warning light has been flashing with alarming regularity.
“Over the last 25 years, the volatility in the S&P 500 has been in the 12% to 13% range,” says DeRoche, Chief Investment Officer and Head of AGFiQ Alternative Strategies at AGF Investments LLC. “The last two years, we've been running in the 19% to 20% range.”
Comparing the daily data for 2022 so far with historical data, DeRoche says volatility in the U.S. equity market up to now remains elevated compared to the past two decades as uncertainty continues to weigh on investors.
Two Years of Turbulence
Looking back to March 2020, the biggest fear was that the pandemic would plunge the world into a deep recession; that was averted by aggressive fiscal and monetary support. Since then, the global economy has been advancing in fits and starts because of new waves and strains of COVID-19, as well as disruptive lockdowns and other government policies implemented in an effort to avoid mass infections and fatalities.
“In November 2020, the market took off after vaccines were first shown to be effective against the virus. We saw unprecedented volatility in reaction to that,” DeRoche says. “In the U.S., we also saw a dramatic reaction this past December and January due to the prevalence of infections related to the new Omicron variant, which included people who’d already gotten vaccinated.”
Many say the current market volatility has strengthened the case for more actively managed investment strategies. That certainly became clear during the tumult of November 2020, when the wave of euphoria in the markets created a riptide that dragged down the AGFiQ U.S. Market Neutral Anti-Beta CAD-Hedged ETF, which trades as QBTL on the TSX, and is meant to hedge against drawdowns in the U.S. stock market by providing negative beta exposure.
“If you think about the strategy itself, it's long low-beta or low-volatility securities, and short high-beta or high-volatility securities. In a reopening portfolio, you’d find all the highest-volatility names,” DeRoche said. “When the market took off in response to news of successful COVID vaccines, that reopening portfolio significantly outperformed, and we underperformed.”
Because QBTL was a purely index-tracking ETF, AGF couldn’t adjust its holdings even as gross leverage and other risk factors to the portfolio shot up. In response to these issues, AGF opted to move the fund into a rules-based methodology, with the ability to react to market conditions and certain risk factors when it’s appropriate.
“A good example is with momentum. It usually works very gradually over time, and it’s nice to have when it’s working for you. But eventually that exposure to momentum gets so high that when it stops working, it tends to crash abruptly,” DeRoche said. “So we've just created a rule where if that exposure gets too high, we're going to cut it back, which we think will improve the investor experience.”
Investors’ evolving COVID response
According to DeRoche, the markets are no longer just blindly reacting in response to COVID waves. Unlike the beginning of the pandemic when the virus was a true unknown, the world has gained more knowledge and intelligence around it, and are more willing to patiently digest data.
The initial response to the Omicron wave was “extremely muted,” he says, because early data out of South Africa showed it caused less severe symptoms and caused less of an issue among vaccinated individuals. But investors’ concerns grew as the new strain proved to be more communicable and breakthrough infections rose.
“As we look out in 2022, the volatility is more from the large distortions we’ve created in the economy,” DeRoche says, citing prevalent supply-chain issues, record-high inflation, and the large amounts of stimulus injected into the markets. “We're going to have to very delicately manage all of these things, and they're all going to create more uncertainty as we move forward.”
With record-high price increases ripping through the economy, all eyes are on the Federal Reserve. While the Fed has historically kept a handle on inflation via short-term interest rates, DeRoche points out the central bank has also been relying on asset sales and purchases to help provide much-needed stimulus. To those with a constructive view, that means it has two tools at its disposal; to detractors, that’s double the chances of making a policy error.
“You could say they’re slightly above the glide path toward a smooth economic landing, and the concern is that they overcorrect as they try to get back,” he says.
At the moment, he says AGF doesn’t see a recession happening. But if policymakers aren’t careful, he says there could be a flattening or inverting of the yield curve, which could lead to a recession and a downturn in the equity markets. AGF worries that investors who have traditionally relied on a long-Treasury portfolio to hedge against equity drawdowns could find that protection isn’t there.
“We're encouraging people to rethink what they're using to hedge that equity portfolio,” DeRoche says, noting that QBTL has a record of doing well during market drawdowns. “The high-beta, high-volatility names in its short portfolio tend to have cash flows way out into the future, so they’re higher-duration assets that are likely to get hurt more in a rising-rate environment. So we do think QBTL will continue to do well in this new period of uncertainty.”
